16/03/2015. FRS 102 & financial instruments hedging. FRS 102 & financial instruments hedging. Introduction

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1 FRS 102 & financial instruments hedging 18 March 2015 Download the slides to accompany the webinar /FRFwebinarresources FRS 102 & financial instruments hedging 18 March 2015 Introduction Marianne Mau Technical Manager, Financial Reporting Faculty 1

Introduction David Rice Senior Manager Grant Thornton Eddy James Technical Manager Financial Reporting Faculty Ask a question Participate in today s webinar send us a question Audio

2 Introduction David Rice Senior Manager Grant Thornton Eddy James Technical Manager Financial Reporting Faculty Ask a question Participate in today s webinar send us a question Audio problems if you experience poor sound quality you may benefit from selecting Use Telephone from your Audio Mode settings Downloading the slides /FRFwebinars (/FRFwebinarresources) 2

3 Contents Hedge accounting basics Qualifying criteria Types of hedge Discontinuing hedge accounting Transition requirements Summary & conclusions Hedging HEDGE ACCOUNTING BASICS Accounting policy choice Under FRS 102 entities can choose between Applying sections 11 & 12 of FRS 102 in full; or Applying the recognition & measurement provisions of IAS 39 and the disclosure requirements of sections 11 & 12; or Applying the recognition & measurement provisions of IFRS 9 and the disclosure requirements of sections 11 & 12 Today s webinar assumes that entities will be applying sections 11 & 12 of FRS 102 3

4 Why do we need hedge accounting? Current UK GAAP FRS 102 Derivatives off-balance sheet Derivatives on-balance sheet Gains and losses recognised on settlement No need for special hedge accounting rules Measured at fair value through profit or loss Hedge accounting can be applied providing certain criteria are met, allowing the economic substance of hedge to be reflected in the financial statements What is hedging? Many entities engage in hedging activities to manage the risks they face When an entity enters into a hedging transaction it uses a hedging instrument to manage an exposure arising from a hedged item The idea is that gains or losses on the hedging instrument will offset gains or losses on the hedged item What is hedge accounting? Under FRS 102 s normal rules, these gains and losses can end up being recorded in profit or loss in different accounting periods, resulting in earnings volatility FRS 102 therefore allows entities to reduce this volatility by voluntarily applying special hedge accounting rules provided certain criteria are met Hedge accounting also better reflects an entity s risk management processes 4

5 Quick example 1 forecast sale Entity A has a highly probable forecast sale of $1m on 30 June It entered into a one year forward contract on 1 July 2014 to sell $1m at a price of per $1. In other words, they are seeking to fix their cash inflow at 625,000. At Entity A s year-end of 31 December 2015, the $ has strengthened meaning the forward contract was out of the money. Quick example 1 forecast sale Without hedge accounting the loss on the hedging instrument is recognised via profit or loss this year but the gain on the hedged item will only be recognised next year when the forecast sale takes place. Gain on hedged item Loss on hedging instrument 31 Dec 2015 Loss on hedging instrument With hedge accounting the loss is deferred via equity until the forecast sales take place. Quick example 2 interest rate swap In 2008, Entity B took out a 20 year loan for 10m. Interest is variable at LIBOR+1%. On the same day, in order to hedge against variability of future cash flows, Entity B entered into an interest rate swap to pay 7% fixed and receive LIBOR+1%. On Entity B s transition date the market interest rate is 2% meaning the swap is significantly out of the money. The fair value of the swap is - 6m. Without hedge accounting this loss goes straight to the profit or loss reserve on transition with a consequential impact on distributable profits. With hedge accounting it could be recognised in the cash flow reserve. 5

6 Poll 1 What type of hedging activities do you or your clients get involved in? Hedging QUALIFYING CRITERIA Hedging relationships Hedged items Exposes an entity to a risk Recognised asset or liability Highly probable forecast transaction Unrecognised firm commitment Net investment in a foreign operation Groups of such items Components of such items Hedging instruments Used to manage a risk associated with the hedged item Usually a derivative Can be any financial instruments measured at fair value through profit or loss (other than, in most cases, a written option) Must be a contract with an external party Partial term is not permitted 6

7 Qualifying hedging relationships Hedged item and hedging instrument meet specified criteria Hedging relationship is consistent with entity s risk management objectives There is an economic relationship between hedged item and hedging instrument Documentation of hedging relationship Documentation of causes of hedge ineffectiveness Not all hedges will qualify Groups of items constituting a net position Intra-group items Macro hedging Poll 2 What do you think the biggest barrier to hedge accounting is? 7

8 Hedging TYPES OF HEDGE Cash flow hedges Hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction Effective gain or loss on hedging instrument initially recognised in equity Outcome is that gains & losses on hedged item & hedged instrument matched in P&L in same period Cash flow hedge - examples Hedged item Highly probable transaction in a foreign currency Variable loan liability Variable loan asset Highly probable sale of commodity Hedging instrument Foreign currency forward contract Swap pay fixed receive variable Swap pay variable receive fixed Forward contract over commodity prices 8

9 Fair value hedges Hedge of exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment Adjustment to the hedged item & hedging instrument remeasured to fair value offset in profit or loss Outcome is that gains & losses on hedged item & hedged instrument matched in P&L in same period Fair value hedge examples Hedged item Commodity asset or firm commitment Fixed rate loan asset Firm commitment to purchase in foreign exchange Hedging instrument Purchased put option at a fixed price Pay fixed receive variable swap Forward contract (can also be a cash flow hedge) Hedges of net investment in a foreign operation Accounted for similarly to cash flow hedges Effective gain or loss on hedging instrument initially recognised in equity but is never reclassified to profit or loss on disposal or partial disposal Normally only relevant in consolidated accounts 9

10 Hedges are rarely perfect Sources of ineffectiveness hedging instrument pre-existing on date of designation timing differences quantity or notional amount differences credit risk prepayment and termination features time value component of options The ineffective portion of a hedge always goes to profit or loss Hedging DISCONTINUING HEDGE ACCOUNTING Discontinuing hedge accounting An entity may discontinue hedge accounting provided it has documented this election An entity must discontinue hedge accounting the hedging instrument has expired, is sold, terminated or exercised the conditions for hedge accounting are no longer met 10

11 Hedge discontinuance cash flow hedge Hedging instrument expires or is sold etc Voluntarily discontinue No longer meets criteria Keep initially in equity Reclassify to match hedged item Hedged item no longer expected to occur Reclassify to profit or loss Hedging TRANSITION REQUIREMENTS Transition requirements FRS 102 originally required documentation of hedging arrangements existing at the transition date to be in place by an entity s the transition date Hedge accounting can now be applied to such arrangements provided that the documentation is in place by no later than the date the first FRS 102 financial statements are authorised for issue The same timeframe applies to documenting hedging relationships that commenced after the date of transition This means that entities will now have up to 33 months after their transition date to create their hedge documentation 11

accounting Cons Must ensure hedging structures comply with the standard Time &

12 Transition cash flow hedges Choice Hedge accounting Not hedge accounting Cash flow hedge reserve P&L reserve Hedging SUMMARY AND CONCLUSIONS Pros and cons of hedge accounting Cons Must ensure hedging structures comply with the standard Time & expense Pros Reduced P&L volatility Accounting reflects economic substance of transaction 12

13 Any questions? Ask a question Participate in today s webinar send us a question Click here to see questions /newukgaap 13

Factsheet and FAQs Financial reporting at

14 Factsheet and FAQs Financial reporting at your fingertips Download the faculty s free app for iphone, ipad and Android devices. Visit /frfapp for more information. You can also follow to keep up-to-date with the latest financial reporting developments and breaking faculty news 140 characters at a time. Questions David Rice Manager Grant Thornton Eddy James Technical Manager Financial Reporting Faculty 14

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15 Future events and webinars Events 28 April London Financial Instruments under new UK GAAP Details of our Autumn roadshow series coming soon /frfevents Webinars See /webinars for details of our upcoming webinars Don t forget you can also access recordings of previous webinars THANK YOU FOR ATTENDING Contact the Financial Reporting Faculty +44 (0) frfac@ Please take the time to fill out our short survey A world leader of the accountancy and finance profession 15

16/01/2015. FRS 102 & financial instruments basic and other debt instruments. FRS 102 & financial instruments basic and other debt instruments

16/01/2015. FRS 102 & financial instruments basic and other debt instruments. FRS 102 & financial instruments basic and other debt instruments FRS 102 & financial instruments basic and other debt instruments 20 January 2015 Download the slides to accompany the webinar /FRFwebinarresources FRS 102 & financial instruments basic and other debt instruments